Capital Investment and Variance Risk Premia

Abstract

We document that the variance risk premium in asset returns decreases firms’ investments.
We theoretically model the premium; we find that it increases the value of the real option
to delay an investment and, thus, influences investments negatively. Empirically, we verify
the negative link between the variance risk premium and investments. Cross-sectionally, the
link is more important for investment-grade firms, which have relatively higher exposure
to systematic variance risk. This premium helps us understand an otherwise surprising
pattern: investments are lower for investment-grade firms with better investment conditions
than speculative-grade. Investment-grade firms basically hedge variance risk by delaying
investment.

Keywords: Real option, Variance risk premium, Optimal timing, Stochastic volatility

JEL Classification: D81, G13, G31